On January 5,the U.S. Federal Trade Commission (the FTC) issued a proposed rule that would effectively invalidate any non-compete agreements between employers and their workers. The rule could materially change the terms of employment for a significant portion of the American workforce, including workers whose existing employment agreements could be retroactively affected by the ban. This article provides practical considerations for businesses in the U.S. as they wait for the FTC to issue a final rule and highlights certain aspects of the proposed rule that could be problematic in practice if the rule is finalized without additional guidance.
The proposed rule was subjected to an extended comment period which ended on April 19, and the FTC is currently reviewing the comments received (you can read our earlier analysis of the FTC’s proposed rule for more detail).
It is worth noting that the enforceability of non-competes in the U.S. in the employment context is currently governed by the laws of individual states, and the proposed rule would supersede this patchwork of state laws. With varying degrees, most states permit non-compete agreements as long as they are reasonable in both duration and geographic scope. There are, however, jurisdictions that impose a near-total ban on non-compete agreements between employer and employee, including California, North Dakota, Oklahoma and Washington, D.C. Moreover, other states have adopted a prescriptive approach that limits or circumscribes non-competes based on the employee’s compensation level or compliance with notice, consent and consideration requirements.
The ban’s broad scope
The FTC’s proposed rule has the potential to materially change the terms of employment and compensation in the ordinary course of business for many U.S. employers that have historically relied upon non-compete agreements to protect their proprietary information and investment in their labour force. This would be true whether the proposed rule is finalized substantially as proposed or whether it is materially revised to provide categorical exceptions to the general non-compete ban, as the final rule will likely be more prescriptive and broader than most of the non-compete laws at the state and local level. Notably, in addition to prohibiting employers from imposing non-compete covenants prospectively, the proposed rule would require employers to rescind existing non-compete agreements and notify affected employees that their non-compete obligations are no longer in effect. As such, U.S. employers will need to consider alternatives to using non-compete covenants, which could include strengthening covenants relating to confidentiality, intellectual property and non-solicitation.
Questions remain for employers
It is not clear whether the non-compete ban, as proposed, would apply to a number of common business arrangements. For example, it is not clear whether partners of a partnership who also provide services to the partnership could be subjected to a non-compete covenant in their capacity as partners. The proposed rule is also not clear on the extent to which an employee placed on a garden leave or an extended notice period could be subjected to a non-compete covenant, since the proposed non-compete ban on its face would not bar an employer from enforcing non-competes against current employees during the course of their employment.
Notably … the proposed rule would require employers to rescind existing non-compete agreements and notify affected employees that their non-compete obligations are no longer in effect.
Further, it would be helpful to receive clarity from the FTC on whether subjecting an employee to a non-compete as consideration for equity grants, severance pay, deferred compensation or other similar benefits would be permissible under the final rule. Such compensatory arrangements typically require forfeiture or claw-back in the event of a breach of the non-compete, such that the non-compete could be viewed as being elective (the employee may choose to forgo the benefit by not complying with the non-compete). Arguably, “elective” non-competes should be treated differently from non-competes that are entered into with a new hire at the inception of, and as a condition for, employment.
Considerations for M&A
If the non-compete ban is adopted substantially as proposed, it could have significant ramifications in the context of mergers and acquisitions.
Specifically, the proposed rule does not make a distinction between rank-and-file employees and highly compensated or executive-level employees. Moreover, the proposed rule allows the “sale of business” exception only with respect to sellers that own at least 25% ownership interest in the business being sold. This means that key employees of acquired businesses that do not otherwise meet the 25% ownership threshold may be free to leave the business following the acquisition and start a competing business or work at a competitor. In order to retain key employees of the acquired business, the buyer may need to implement more robust retention and incentive compensation programs.
For these reasons, the FTC’s non-compete ban could adversely impact the perceived value of the target company during negotiations and ultimately put downward pressure on the purchase price.
What comes next?
At the time of this writing, the FTC’s non-compete ban is still in a proposed form and has not yet become a final rule. The rule may also be subject to a number of legal challenges, which may delay or ultimately prevent the rule’s implementation. However, employers may wish to start the process of identifying who in their workforce is currently subject to a non-compete and consider how best to protect their business interests if and when the non-compete ban becomes effective.